July 28, 1998
Jonathan G. Katz, Esq.
Securities and Exchange Commission
450 Fifth Street, N.W., Stop 6-9
Washington, DC 20549
Re: Comment Letter on Proposed Regulation of Exchanges
and Alternative Trading Systems, File No. S7-12-98
Dear Mr. Katz:
Americas financial markets are undergoing a rapid structural change. Market participants, their capital and order flow now trade freely between exchanges and
non-exchange markets, principally as a result of exponential growth of inexpensive communication links, sophisticated technologies and deregulation. Never has the latter combination produced such a dramatic impact as its application to Alternative Trading Systems (ATSs) for the handling of orders in securities and commodities. In order to be competitive in this evolving marketplace, market participants and marketplaces must recognize this new paradigm and respond by embracing new systems, services and technologies that offer the global investor leading edge information and execution products at cost effective prices. Those who lack this strategic vision will soon see their business niche and market share swept away by these strong new undercurrents. In this new wake, investor choice will reign, providing investors with an increasing array of products and services, available during expanded hours, and at dramatically lower costs.
The Commission must remain vigilant in maintaining America as the foremost financial marketplace in the face of mounting international competitive threats and pressures. Towards this objective, the ATS market regulatory framework should encourage market innovation, but remain true to the National Market System (NMS) principles of fostering market liquidity, transparency and efficiency. The market structure must ensure full integration of all orders into a fair, open, and transparent environment in accordance with the vital Congressional mandate to develop an NMS articulated over 25 years ago.
Ashton Technology Group, Inc. (ATG) applauds the Commissions
pro-competitive philosophy that permeated last years Concept Release (Release No.
34-38672) and this years proposals to allow exchanges and ATSs a broad and appropriate range of regulatory choices on how they may conduct their businesses (Release No. 34-39884) (ATS Release). [ The Commission states that "(a) fundamental objective of the Commission’s proposal is to create regulations that are sufficiently flexible to accommodate the chosen business objectives of the various alternative trading systems, including those that elect to register as exchanges." See ATS Release, at text accompanying n. 164.] Additionally, we are proposing certain modifications to the proposals to assist the integration of public and institutional orders in the NMS.
ATG believes that the Commissions well integrated and bold approach will create a market structure that will foster gargantuan opportunities whereby market forces spurred by technology and innovation will create new products, systems and services, opening new vistas to investor choice.
ATG supports the Commissions proposal to level the playing field for traditional exchanges by excluding from rule filing requirements certain pilot trading systems and new derivative securities to be launched by national securities exchanges and associations. ATG also applauds the Commissions guidance and flexibility in offering non-membership, for-profit ATSs to become registered and to operate as national securities exchanges.
ATG notes that the existing notice and comment process, coupled with protracted Commission review with no assurances of regulatory approval creates enormous business uncertainties, significant disincentives to being a pioneering innovator and raises substantial fair competition concerns for any trading system creator subject to self-regulatory organization (SRO) rule filing procedures. Substantial delays once an innovators new trading system or product is telegraphed in great detail through the notice and comment process to actual and potential competitors unfairly permits the latter to copy, catch up or further delay the launch of the innovators system or product. Indeed, we believe that in many cases the comment process is mainly used by other market participants to delay or block the system or product because of a perceived or actual threat of the new system or product to take away the formers market share. This practice similarly exists in the context of the Commodity Futures Trading Commission (CFTC) proceedings. [ For example, two new electronic trading systems for futures trading, Cantor Financial Futures Exchange and FutureCom, are experiencing frustration and delays in receiving CFTC approval of their systems applications, no doubt in part caused by the barrage of questions and adverse comments by the existing open outcry exchanges. See letter from W. H. O’Brien, Manager, FutureCom, to A. Seifert, J. Lawton and L. Gregory, CFTC, dated January 5, 1998. In pertinent part, FutureCom states: (y)ou (CFTC) have asked us to disclose large amounts of information I regard as proprietary. Your stated reason was to satisfy the large exchanges who feel a need for more information in order for them to make a determination if FutureCom has received the same amount of scrutiny from CFTC staff as given their electronic trading systems. I will go way out on a limb and predict that, no matter what level of disclosure from FutureCom, the three large exchanges will find our submissions wanting. The comments offered are simply an attempt to delay our approval, drain our resources and discourage any future competitive threats. I have read the letters submitted during the comment period. It is encouraging to me that the only negative comments were from the very predictable sources. While the large exchanges "are strong believers in the value of competition and the innovative use of technology in the futures industry," I fear their concerns about our application will never be satisfied. I do find some comfort in the fact that their investigations have led them to conclude that the Internet is not appropriate for commodity trading and this declaration defines the future for their trading pathways…. The only logical interpretation of comments from NYMEX, CBOT, and CME is as a request for an assignment from CFTC of absolute veto rights over any Commission decision to approve our application. They are requesting of you information, whereby, they might decide if the CFTC has subjected FutureCom to the rigorous and stringent scrutiny that they believe is necessary. We believe their alarmist mischaracterization of our Exchange has only one purpose – to postpone or prevent our approval for trading. They propose acting as a proxy for the Commission and are happy to assist you in setting the impossible standards of our approval….] The Commissions proposed deregulatory measures for exchange pilot trading systems and certain derivative securities are a much needed and good start toward allowing market forces to determine the system or products marketplace acceptance and ultimate efficacy.
ATG believes that the Commission should rapidly move to a policy whereby the launch of any new trading system by any exchange-like organization is not subject to any governmental pre-introduction approval process. [ We note that the Commission has excluded upstairs’ dealer systems from the definition of "exchange." Accordingly, such systems that execute tens of millions of shares in both listed and NASDAQ securities today completely escape any appreciable systems regulation. Moreover, such dealer systems have huge competitive advantages of being introduced and constantly modified without Commission approval and advance notice to competitors. See e.g., "Time Slicing" system offered by Bernard L. Madoff Securities, a third market dealer. We propose that instead of subjecting systems such as Madoff’s to an advance notice and Commission approval process, the Commission should remove such requirements from those currently subject thereto.] The Commissions role should only be to establish certain broad guidelines/regulations for all system sponsors to follow in designing and providing access to their systems, and enforcing such requirements post trading system launch. This regulatory approach will provide the fairest and most level playing field for all engaged in exchange-type activities. Again, we see that this is the philosophical direction in which the Commission is heading and we strongly advocate the Commission to continue down this path.
The Commission has encouraged broker-dealer ATSs to consider registering as national securities exchanges and has provided practical guidance on how ATSs can comply with the standards of Section 6 of the Securities Exchange Act of 1934 (Exchange Act). First, we agree that only registered exchanges should be able to incorporate "exchange" or a like term in their names so that all market participants, including public investors, can readily discern the existence of an organization subject to the highest level of regulatory standards and oversight.
Second, we support the current and continued ability of any exchange to contract to another SRO its day-to-day enforcement and disciplinary activities. ATG has and will continue to develop comprehensive and instantaneous records that can be monitored remotely with respect to all trading systems that it develops and deploys. We believe that our leading edge electronic surveillance systems may create a new standard of regulatory monitoring integrity.
Third, with respect to the "fair representation" requirement for exchange governance, we believe that a profit-driven exchange should be afforded considerable flexibility in its formative business stages with respect to this area. In this regard, the entrepreneurial owners should have maximum control in directing the startup exchange in the quest for order flow and market share. Once the exchange achieves a consistent market share such as five percent (5%) in listed or NASDAQ securities, the reins of the exchange may be shared with more customer-based representatives and others. At this point, the exchange, as a result of its market share, takes on a more public utility nature. Up to this point, however, ATG believes that owner-oriented directors with the creative ideas will be best for nurturing an environment that will provide the best opportunity for success of the exchange as a new business enterprise. ATG also supports the use of advisory committees to the exchanges governing body composed of users and public representatives to give input and insight into the exchange governance and rulemaking process.
ATG believes that certain ATSs will see benefits in becoming exchanges, provided that they directly participate in the listed, NASDAQ and/or derivative securities reporting plans, Intermarket Trading System (ITS), and the Options Clearing Corporation (OCC). The means of access to and participation in these joint industry organizations are not clearly defined and thereby provide the current participants an inappropriate opportunity to delay and set unreasonable terms and access conditions to these critical facilities. The past is replete with examples of how new participants have been delayed or outright precluded from access without direct Commission intervention, e.g., NASD admittance to ITS, ITS-CAES interface ordered by the Commission and proposed to be expanded, see Release Nos. 34-17744 (April 21, 1981); 34-40260 (July 24, 1998).
A major part of the problem is that virtually all current joint industry plans have been drafted to require unanimous assent of all current participants regarding plan amendments and admission of new participants. Accordingly, each existing participant has absolute veto power over new plan entrants. Therefore, the Commission must drive the process of assuring the timely and reasonable access of new exchanges to NMS mechanisms. The Commission must be acutely sensitive to veiled anti-competitive motives of the existing plan participants and be prepared to direct any new qualified entrants to be accepted into all NMS mechanisms such as ITS, Consolidated Tape Association (CTA), Consolidated Quote System (CQS), Options Price Reporting Authority (OPRA) and OCC.
With respect to those ATSs which opt not to register as exchanges, we conceptually agree with matching the degree of regulatory standards applicable to an ATS with its level of consolidated share trading volume. In this regard, we believe that there should be only two regulatory categories determined by a market share break point. We believe that such break point should be one percent (1%) of aggregate, consolidated share volume as measured every six (6) months. An ATSs share of listed securities would be considered separately from its share of NASDAQ securities. We see this standard efficient to implement in comparison to a security-by-security measure. We also believe that the higher regulatory standards should apply across-the-board to all securities in a pertinent category traded by an ATS once it achieves a one percent market share of all consolidated share volume in such category. This measure better reflects the relative importance of the ATS in the NMS and removes any advantages for an ATS to throttle volume in a particular security or handful of securities to avoid triggering the higher requirements.
In contrast, ATSs that represent less than a one percent (1%) market share would comply with the minimal requirements of proposed Regulation ATS, e.g., file Form ATS, perform minimal recordkeeping, undergo quarterly reporting and comport with bare essential trading information confidentiality requirements. ATSs representing a one percent or greater market share would be required to adhere to the remaining higher standards contained in proposed Regulation ATS with our following suggested modifications.
For the higher volume segment of ATSs, the Commission should require the highest standards of capacity, integrity and security respecting ATSs systems. [ We believe that the heightened capacity, integrity and security standards for reported equity securities should be triggered at one percent of consolidated volume in a category of equity securities, e.g., listed and NASDAQ securities. With respect to debt, limited partnership interests and listed options, the Commission’s proposed 20 percent of the volume in a category threshold for triggering the standard is appropriate, but may not be feasible for debt and limited partnerships due to difficulties in ascertaining actual volume levels. ] Additionally, the Commission should require longer record retention (5 years/3 years in an assessible location instead of 3 years/2 years assessible) and more frequent transaction reporting (monthly instead of quarterly). The stricter information collection procedures should assist Commission monitoring of the effect of ATS operations on market quality and structure. Records and reporting should be primarily between the Commission and the ATS with access by the ATSs affiliated SRO provided on a confidential, need-to-know basis. In this respect, as SRO sponsored systems start to compete directly with ATSs, SROs should not be permitted to obtain undue competitive advantages over ATSs through this regulatory reporting process. [ For example, many NASD member firms view some of the NASD’s own sponsored systems as being in competition with the former’s execution services. In this regard, E. E. Geduld, President of Herzog Heine Geduld, recently stated: (t)he limit-order file and the OptiMark system (both being directly sponsored by the NASD) have a lot in common – not that they work the same way. Philosophically, I’m opposed to the whole file. We have a regulator creating an ECN of its own. I find that repugnant. It’s just not the way things are done in the United States. You can be either a regulator or a businessperson, but I can’t imagine any way you can be both. It would be as if General Motors (Corp.) became the regulator of the automobile industry. People would allow that to happen for about a second and a half. When the NASD becomes my competitor and remains my regulator, there’s something wrong in the system. BLOOMBERG, April 1998, at 30.]
The Commission is correct in attempting to enhance the integration of the higher volume ATSs into the public quotation system, but ATG would suggest that all ATSs, no matter what their volume, be subject to higher transparency requirements. [ In this regard, ATSs should have direct representation in CTA/CQS, NASDAQ Transaction Reporting Plan and OPRA without the necessity of becoming registered exchanges. ] The Commissions mandate to facilitate an NMS for securities necessitates this action. The Commission must assure transparency and maximum interaction of trading interest among all NMS participants. To reduce adverse market impacts, protect anonymity and provide negotiation and reserve size techniques, which allow the "two tier" system of public and institutional orders to interact without fragmenting the market, we strongly believe that for orders up to 10,000 shares, the full order size should be disseminated, and for orders in excess of 10,000 shares, a minimum of 10,000 shares should be represented publicly. We believe that this strikes the appropriate balance between minimizing market impacts of large orders and displaying a representative portion of those orders to the marketplace so that contra side "public" interest has access to the critical pricing information necessary to make informed investment decisions and secure best executions.
A corollary rule would require that all public participants have exposure to and ability to execute against all order interest in an ATSs system. [ In this regard, we believe that "equivalent" access (which includes non-discriminatory system fees) should be a requirement, but we are against the notion that access be linked through an SRO execution system only. We envision that all non-subscribers will be affiliated with a clearing firm that would have direct access to the ATS thereby providing the former with such equivalent access to the ATS. We also strongly urge modification of the ITS Plan to accommodate direct ATS participation in ITS, which could constitute another "equivalent" access route to ATSs by non-subscribers. ] Accordingly, an ATS could have negotiation and reserve size features so long as the public has equivalent access to those features. In this regard, preferencing features that only allow select subscribers to negotiate or have access to a system subscribers reserve size should be prohibited.
Finally, the Commission should consider amending the Quote Rule, Rule llAc1-1 under the Exchange Act, to require all exchanges, over-the-counter dealers, and ATSs to disseminate to the public quote system market interest behind the best bid and offer quotations emanating from each market. [ Rule 11Ac1-1(b)(1)(i) and (ii) currently requires exchanges and the NASD to "make available to quotation vendors the best bid , (and) the best offer ." Emphasis added.] In the advent of the Commissions order handling rules, public displayed quotes have tightened and spreads have narrowed. Nevertheless, while price information makes the markets appear tighter, sizes associated with the narrower quotes often are for nominal size masking the "real" interest or market that lies underneath those displayed quotes. It is now imperative for the Commission to provide to quote vendors for display in the public quotes a "band" of quotations with size that more accurately portrays market and liquidity conditions. [ For example, the Stock Exchange of Hong Kong’s AMS system "displays the best ask (bid) price along with the next four best ask (bid) prices and also lists the broker numbers of those brokers with orders at each price. This information enables the broker to gauge the price range." See L. YOUNG & R. CHIANG, THE HONG KONG SECURITIES INDUSTRY 105 (3d ed. 1997).] Without such a requirement, ATSs will continue to constitute "hidden" markets which provide advantages to only their subscribers to the detriment of the non-subscriber public and the marketplace in general. We, therefore, suggest that the Commission examine several approaches to ameliorating this hidden market condition by requiring ATSs to disclose their top five best bids with size and top five best offers with size; or a price or percentage band of interest around the consolidated best bid and offer quotes (BBO), e.g., disclose all bids and offers with size within $1 of the BBO.
We certainly recognize this enhanced quote disclosure rule should be applicable to exchanges and NASD sponsored trading systems for the same policy reasons it should cover all ATSs. The enhanced quotation disclosure will level the informational playing field for all market participants and give the increasing number of institutional traders as well as public investors a better assessment of true market liquidity that should improve their opportunities for receiving best execution of their orders.
Due to the importance of high volume ATSs to the NMS and to assist market participants in identifying where to seek the best priced quotes, we suggest that the Commission consider affording ATSs their own unique market identifier. In this respect, such ATSs as a class would be identified by a separate market identifier that distinguishes them from exchanges and third market and other over-the-counter dealer quotes and trades. This will aide investors in seeking best execution and will also assist the Commission and market statisticians to better monitor and evaluate the effect and extent of ATS trading.
Once again, ATG applauds the Commissions pro-competitive, forward looking regulatory approach that will provide all market participants an open door to unimaginable opportunities, and assure that American financial markets continue to be a world leader. In this new structure, technology will continue to be a powerful tool in our marketplace making possible an ever increasing array of investor products and services, available during expanded hours, and at dramatically lower costs. We look forward to the challenges ahead.
|Fredric W. Rittereiser||William W. Uchimoto, Esq.|
|President and Chief Executive Officer||Executive Vice President and General Counsel|